Fractional-Reserve Banking and the Sharing Economy

At first thought, it’s kind of funny that people pay so much for cars, given that they mostly just sit parked. But thinking about it a bit harder, maybe a car sitting around most of the day serves a greater purpose. If it is the cheapest price to pay for on-demand transportation, then it makes a lot of sense. Likewise, owning a cottage seems wasteful if it is only occupied a couple days a week, but if that is the most convenient way to have on-demand weekend getaways, then it too makes a lot of sense. In both examples, the opportunity costs of idle resources are outweighed by their benefits.

The reality is that uncertainty and the problem of coordinating with others plague most of what we want to do in life. I may know I want to travel in the future, but I may not know exactly when and where. I could hope to use a bus or to borrow my friend’s car, but I can’t be certain the bus goes where I want or that my friend won’t need his car at the same time. Likewise, I may want to swim and fish, but I don’t know when I’ll have the free time to do so. I could hope to borrow a stranger’s cottage for a price, but how do we coordinate a time that works for both of us, and how do they know to trust me?

These are the problems the sharing economy is currently solving: on-demand vehicles and housing, coordinated in a way I could not do on my own, and with rating systems that achieve a level of trust I could not get on my own. Companies such as Uber and Airbnb have made possible the benefits of on-demand travel and on-demand housing while drastically lowering the idle-resource costs.

But my goal here is more than just getting excited about Airbnb and Uber. I want to show that one industry has been giving society these types of benefits for centuries: banking. Much like Airbnb has done with homes and Uber is doing with cars, banks long ago found a way to lower the opportunity costs of idle resources. We hold onto money for the same reason we keep cars sitting in the driveway: overcoming problems with coordination and uncertainty.

Fractional-Reserve Banking

Fractional-reserve banking allows banks to issue notes of redemption for base money (outside or government money) in such a way that not only are there more notes than units of base money, but also these notes circulate as a medium of exchange themselves. (Don’t think about literal paper notes anymore, but any money created by banks — i.e., what’s on your debit card.) Fractional-reserve banking allows customers to redeem notes on demand while reducing heavily the amount of money that sits idle. (Larry White gives a more detailed account of how fractional-reserve banking came about and how it works here.)

It may seem wasteful to hold money under the bed or in a storage warehouse, but before fractional-reserve banking, it wasn’t. It’s just like keeping a car in the garage or a cottage for only the weekend: sure, it’s idle most of the time, but it’s there when you need it. Nonetheless, it was and is costly. Fractional-reserve banking should be seen as having solved the problem Airbnb and Uber are trying to solve now: idle resources stemming from the high transaction costs of coordination and uncertainty.

Similarly to all other sharing economies, this reduction in transaction costs provided by a fractional-reserve system tapped a new and impressive source of revenue that makes both the banks and their customers better off. A fractional-reserve system is preferred by customers because they get to share in the profits of the money loaned out by the banks. It is this practice that allows banks to offer interest and other benefits on accounts without sacrificing liquidity. This brings on some new risk, but under competition, market forces will have companies eventually strike a balance between actual profit and projected risk.

In general, the sharing economy makes for a more elastic supply, where supply quickly changes in response to demand. The supply of hotel rooms in any given city was pretty inelastic until Airbnb came along. Now, when hotels are all booked, people can rent out their extra bedrooms in their homes, and this allows the supply to increase instead of the price, which is great for consumers.

Ride-sharing companies such as Uber can quickly decide the size of the fleet they need and the size of the customer base they can credibly promise on-demand rides to. If societies’ tastes change such that people are demanding more car rides, Uber simply needs to increase its fleet size. They can do this by raising their price (surge pricing) and thus incentivizing more drivers to get on the roads.

Banks have always done basically the same thing. Based on their gross clearing activities, desired risk, and other factors, they can figure out an equilibrium ratio of the notes they create to base money, such that almost no money is sitting idle but no one is denied redemption of their notes as their contract states they are entitled to. If society’s tastes change such that people demand to spend more notes (demand to hold onto notes falls), banks would need to either increase their total number of reserves or cut back on the number of notes in circulation to maintain the new, higher rate of redemption. One way they could do this would be by raising their interest rate on loans. Or if people start to want to spend less, and therefore increase their demand to hold notes, then banks could either hold fewer total reserves or simply increase the number of notes they create by lowering their interest rate on loans. (George Selgin gives a more technical explanation of these processes here.)

Thus, supply can be made more responsive to demand. Like all other aspects of the sharing economy, fractional-reserve banking means people can get more for less. With Uber, there’s more traveling with fewer total cars; with Airbnb there are more heads under our roofs without there actually being more roofs; with banks there’s more investment and less total base money sitting in vaults. Loans that would have been too costly (not just in monetary terms, but in terms of other transaction costs as well) can be reduced to a more attractive price as banks solve coordination and uncertainty problems for us. Fractional-reserve banking puts resources to work.

The future has a lot of potential awe-inspiring inventions coming down the pipeline. But while daydreaming about these, we shouldn’t forget to be in awe of the invention of fractional-reserve banking. Long before fancy apps, and indeed long before the internet even, it was solving our problems and making our lives better.

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